Latest Wall Street Sting and How It Works

18May2012

Written by Michael A. Cohen

HINT: YOU’RE THE MARK - The title in the 1973 movie The Sting refers to the moment when a con artist finishes the con and takes the mark’s, or victim’s, money. If a con game is successful, the mark does not realize he has been cheated, at least not until the con men are long gone. The particular sting in the movie was an elaborate confidence game known as "the wire" where a slew of con artists create a phony off-track betting parlor. The mark was a Chicago Mob Boss, Doyle Lonnegan, played by Robert Shaw, who is led to believe that he is getting accurate wire transmissions from Western Union before the results of already run races are made public. Wouldn’t that be a dream bet? Lonnegan thought so and you know what? – on Wall Street it has become a reality. And the “mark” is …

Consider, there was a time not that long ago (pre-2007 or so) when the individual investors were the dominant force in the market. Buying a stock was equivalent to betting on the behavior of the other market participants’ opinion of the company.

No longer, today markets react to economic news in a fraction of a second with computer algorithms (“algos” in industry parlance) that execute millions of orders a second and scan dozens of public and private marketplaces simultaneously.

They can spot trends and change orders and strategies before other investors can blink an eye, or more likely much faster than that.

As much as 80% or more of the trades on a given day may be executed in that manner (up from 60% in 2007). This creates a situation where heavily traded stocks in the S&P 500 or Dow rise and fall for reasons that are nearly impossible to understand at the individual stock level.

Ever wonder how hedge funds and large investment banks like Goldman Sachs and JP Morgan are making so much money so soon after the financial system nearly collapsed? Rapid high frequency trades as the complex computer algorithms find imbalances and tiny advantages that are exploited to make profits that may, in some cases, only be a penny, or less. Yet in the aggregate these trades can move billions of shares a day as these programs jump in and out of the markets across various stock, currency and commodity exchanges.

For example, as Jeff Augen explains in “Trading Realities”, a program might decide to take a long position on S&P 500 futures because, for a brief instant, a predefined mixture of ratios between the price change of gold, bonds, the S&P 500, and a basket of currencies seemed to be slightly distorted.

“If many such computer programs were used by investment houses to detect the same changes there might be a surprisingly large price change as they all opened long positions ( long means buying in Wall Street parlance). The upward price change might be followed by a rapid reversal when the trades are closed (sold), possibly in only milliseconds.”

Sometimes a series of such events result in what appears to be a trend. These events visible to the private investor, you and me, give rise to a sense of predictability and we may make investments or trades based on that, yet we are actually being tricked by randomness. Indeed, large institutional traders have even resorted to creating programs that are designed to trick other programs into taking positions.

Also those same institutional traders will test the market by rapidly placing and closing smaller orders to see what the price the market will bear before committing to larger trades. A private investor with an internet-connected computer, a trading platform, and technical analysis software is no match for these systems.

“This is where all the money is getting made,” said former chairman and chief executive of the New York Stock Exchange William H. Donaldson back in 2009. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”

And Joseph M. Mecane of NYSE Euronext offered a vivid assessment of reality. “It’s become a technological arms race, and what separates winners and losers is how fast they can move,” he said.

Since very brief timeframes is the key to trading in real time, the banks have their large computer servers connected directly to the exchange, and as close as possible, where each foot closer gives them a nanosecond advantage. They are able to trade in and out positions before private investors, again that’s you and me, can even detect the changes.

They are even rewarded with discounts by the exchanges for being directly connected to the exchange.

So, not only do the large investment houses have software and hardware out of the league of private investors, but as in The Sting, a con is being played, but this time it is on us. The banks are getting the results of the “horserace” BEFORE we do. The exchanges are facilitating the advantage and in effect are playing the con on us.

And this is allowed by the various exchanges, New York Stock Exchange, NASDAQ et al, with the blessing of the Securities Exchange Commission which claims it increases liquidity in the market. The SEC, the public’s (supposed) watchdog has, in the words of Shakespeare’s Marcus Antonius, delivered “the most unkindest cut of all”.

Note as an aside: Cathy O’Neil, PhD in Mathematics, said in an episode of Frontline, her job as a quant at the hedge fund D.E. Shaw, was to predict when pension funds would buy or sell assets so her traders could “frontrun” the trade, [that is buying or selling an asset, say IBM stock, ahead of the pension fund thereby benefiting from the change in price as the pension fund moved the market] essentially skimming off the top of some elderly couple’s retirement money.

(Michael N. Cohen was formerly a financial advisor with PaineWebber and UBS (United Bank of Switzerland). He is a Board Member of the Reseda Neighborhood Council, and is an occasional contributor to CityWatch.) -cw